The truth behind US growth

“Let us make future generations remember us as proud ancestors just as, today, we remember our forefathers.” Roh Moo-hyun

For a lot of macroeconomists, the 2008 financial crisis provided the much needed kick-up-the-backside that was missing throughout the previous two decades. From their ivory towers, they reflected on what had been missed, what should have been done and, more pressingly, what could be done to resolve the situation at hand. On the ground though, the crisis was whole lot more than just another intellectual game. Jobs were lost, lifetime savings were wiped out and millions of lives were ruined. This post tries to explain US economic growth since the crisis, and forms an argument for easy government policy for some time in the future.

The chart above shows US real GDP per capita (GDP adjusted for population and inflation) from 1860 to 2000, taken from Jones (AER, 2002). It shows that, incredibly, living standards in the US (proxied by GDP per capita) has grown more or less by 2% per year for the past 150 years. There are two obvious blips - the major contraction of GDP in the 30s, called the Great Depression, and the following boom, known as World War 2. Updating this chart to today, we get the chart below, which shows US GDP growth per capita from 1960 to 2014 (look at the red line, for now). The yearly growth in GDP per capita in this period also sits around 2%. Amazingly, almost as if a law of nature, the US has grown (in per capita terms) by around 2% per year since 1860! What are the driving forces behind this incredible feat?

The theory

When thinking about growth, it is hard not to start with the Solow model. The Solow model, first characterised by Robert Solow in his seminal 1956 paper, characterised economic growth per capita as dependent on two things - technological progress and capital accumulation. In particular growth, it states, can occur in two ways:

1) Through the accumulation of savings, which is subsequently invested into new capital (infrastructure, buildings, know-how etc). 

2) Through technological change, which expands the frontier of growth possibilities for an economy (for example computers, inventions, innovation etc). 

The problem with option 1 is that there is an implicit ceiling on the proportion of income you can save - 100% (assuming no borrowing). Consequently, there is an implicit cap on how much an economy can grow. During the 1960s, Russia chose this growth option and found out the hard way. By reaching the maximum proportion they could feasibly save, they saw their growth and economic status fall by the wayside. The important implication of the theory therefore, is that for a country to go infinitely, it has to be primarily through the channel of technological change. This seems to be the case with the US over the past 155 years. Indeed, the savings rate has remained fairly constant through this time too, further suggesting that growth was mainly through technological change. 

The common misdiagnosis of growth

When referring to the financial crisis, commentators tend to link the downturn with a fall in the capital stock. I hear phrases like ‘the financial crisis destroyed some of the capital stock’ or ‘the US capital stock was cut to below equilibrium levels during the financial crisis’ over and over again. Once the capital stock falls, so does its depreciation. And so, the model dictates, as savings remain unchanged, accumulation of capital (=savings) is above the rate of depreciation causing the capital stock to rise until these two  are once again equal - in equilibrium. This means that GDP rises to the same level it was before the crisis and then continues growth from there. This would look something like the blue line in the chart on the right. Unsurprisingly then, these same commentators end up confounded when GDP looks like the red line instead - there hasn’t been this ‘catch-up’ growth, but rather the economy just grows at the same rate but from a lower level.

What if the crisis has affected the US in the second way? - a reduction in technological change, otherwise known as a negative productivity shock. Put simply, the financial crisis has resulted in a onetime reduction in the frontier of economic growth, pushing GDP lower. But importantly, there is no ‘catch-up’ because the equilibrium level of GDP itself has fallen. This is actually quite plausible. Given that investment these days is predominantly funded by financial markets, its distortions following the crisis could easily have made funding for innovation and technological advancements more difficult. When added to the increased risk-aversion by companies and hysteresis effects of long periods of unemployment, it is quite conceivable that the crisis resulted in a negative productivity shock to the economy.

One problem with the Solow model is that it doesn’t specify how technological progress happens - it is assumed, in economic parlance ‘exogenous’, some sort of manna from heaven. To understand how innovation and technological change occurs, we look towards other theory, namely Endogenous Growth Theory. The specifics of the different theories are irrelevant for our purpose, but the important takeaway is that for innovation grow constantly, it must be linear in itself - i.e. it cannot depend on the level of innovation. No matter what level of innovation there is, the growth in innovation will restart itself. So for a country already at equilibrium and growing predominantly through technological change, growth restarts itself at any point. Indeed this is exactly what we see in the chart - there was a one time reduction in GDP, but then its growth continued from the lower level (the red line). 

The bottom line

Ultimately, policy makers should aim to reduce the reduction in welfare stemming from such crises. If the recession was due to the destruction of capital, the welfare loss would be small - something like the (badly drawn!) blue shaded area. But if it is due to a negative productivity shock, as this post suggests, the welfare loss is very large - the red area plus the blue area. Note the red area will continue to grow as time passes. Policy makers should try their utmost to bring the economy as quickly as possible to the blue line, with easy monetary policy and increased government spending. 

When faced with a crisis, policy makers should do all in their power to achieve two things. First, to make the current generation’s lives as prosperous as possible given the current circumstances. And second, ensure future generations do not pay for our mistakes today. By violating these two tenets of policy making, we may well find ourselves making the lives of future generations not better, but worse.